02 November 2017
Don’t panic!
We should not be concerned by a rise in UK rates.
by Frank O’Nomics.
After a 10 year gap, the first rise in UK rates might be seen as a momentous event. A decade of cheap, readily available credit is coming to an end so surely we need to be careful about how much we borrow and spend if the cost of mortgages and other debt repayments is about to rise (40% of mortages are on a variable rate and so many will feel the impact of a rise immediately), particularly when the real value of our income is being eroded by inflation outstripping wage growth? Add in dubious medium term employment prospects linked to Brexit and we could be forgiven for thinking that a rise in interest rates will require us to tighten our belts. However, while not wishing to make light of the impact of a rise in the costs of servicing exceptionally high levels of personal debt, the turn in the interest rate cycle may be both barely perceptible and in many respects a positive step.
First of all we should not get too concerned about the extent to which interest rates are likely to rise. Yes, inflation is running well above target, at 3%, and is likely to stay above the Bank’s long-term objective of under 2% for the next 3 years, but the momentum behind the rise is already fading. Average earnings growth remains stuck close to 2% despite the lowest level of unemployment for over 40 years. Further, while low productivity means that small rises in earnings can have a pronounced effect on unit labour costs, the Bank of England is more likely to be concerned by the decline in real earnings making it difficult for consumers to keep spending. Wages are unlikely to create much additional inflation pressure while the growth outlook remains so disappointing.
The 0.4% rise in quarterly GDP may have been enough to convince most economic commentators of the imminence of a rate rise (0.3% had been expected) but it still represents a low level compared to historic rates of growth. With forecasts likely to be revised down, based on low business investment and consequent minimal productivity growth, it would, other than for the inflation outlook, normally be quite strange to be looking at a rise in rates. The bottom line then is that, while the rate cycle may have turned, the pace at which rates will rise is likely to be glacial, and the ultimate neutral level of interest rates is unlikely to be much higher than 2%.
Beyond not being concerned by the level to which rates will rise, we can also look at the positive impact of the process. Consumer debt levels in the UK are running at levels which are not sustainable, rising at 10% per annum, when household incomes are growing at closer to 2%. There is a fine line between creating a new credit crisis, where a rise in rates forces borrowers to default, and discouraging a continual build up in debt, but a modest rise in rates could be enough to prevent the bubble building. On the other side of the coin, savers have long suffered an income shortfall due to the low level of interest rates. It is wrong to assume that all pensioners are living comfortable lives on final salary schemes – many have had to eat into their savings to subsist and, while any rise in the interest paid on savings will be modest, the rate of attrition will slow. For pensions overall, as long as the equity market is not seriously undermined, the prospect of pushing up interest rates on longer-term gilts (the assets that are used to calculate pension liabilities) is a positive in that it can help erode some of the shortfall in many corporate pensions schemes. A very small rise in gilt yields last month helped knock £10bn off the cumulative level of UK pension deficits, but it is still calculated at £410bn.
The low level of interest rates has been a tremendous help in keeping the cost of government borrowing down. Clearly there will be some impact on the future costs of funding the national debt, but so far the movement in gilt yields suggests that this will be modest – 10 year gilts currently yield 1.33%, which is only slightly above the levels seen this time last year (1.24%). Also, we should not forget that there is a sizeable offset if the Bank is successful in containing the level of inflation. Over 25% of the gilt and treasury bill market is accounted for by bonds that pay interest linked to RPI. If raising rates succeeds in containing inflation then this reduces the costs of servicing that part of the national debt.
The economy as a whole should receive a long term benefit from a deterioration in the number of so called “zombie” firms – ultra-low growth companies which have managed to survive only because of low interest rates. There may be a short term hiatus as some are forced into administration, but there will be longer term benefits developing from improved productivity as resources are better employed.
We must remember that the adoption of very low interest rates was an emergency measure. A rise in rates is a sign that the malaise prompted by the 2008 financial crisis is finally behind us, and surely this must be a good thing. We should also take some reassurance from the fact that there is a general global withdrawal of cheap money – US rates have been on a rising path for some time and even the ECB has announced a reduction in the pace of quantitative easing. This is the right time to start returning rates to a more normal level, but there is a “new normal” and it is not one that most of us should worry about.
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